The Internet is an exploding business opportunity for
many of us. In 1997 there was $10 billion in business on the Internet
in 2002 it is estimated to be 220 billion! There are many unanswered
questions on how this business will be taxed at the state level.
Recently, the President placed a three-year moratorium
on the states from adding any additional taxes to the Internet then
those that already exist. Many people think this means there is a free-for-all
in that you do not have to pay state taxation on Internet business other
than in the state where your business operation is located. Worse yet,
many people think they can live anywhere and run their money through
a state like Nevada with no state personal or corporate income tax and
pay no state taxes in the state from which they do their work. This
is simply not true.
In fact, most seem to forget that the Internet is very
similar to the mail order business. Meaning, if you sell a tangible
product by sending information around the country, and everyone has
to send a check to your home office and the product is shipped out of
your home office, then you do not have to register as a foreign corporation
in those other states (this falls under Public Law 86-272). If you actually
travel to a state with your products and collect a check in another
state, as opposed to the check coming to the home office and having
the product shipped from there, you then are beyond the protection of
Public Law 86-272 and may have to register as a foreign corporation
in the other state. If you sell computers to someone in your state you
would charge him/her sales tax. If someone out of state ordered a computer
from you and you shipped it to him/her, that would not be subject to
sales tax. This all changes when an intangible product like services
is involved. It is much easier with services to be considered doing
business in other states than with tangible products. You must then
examine the frequency of doing business in another state with intangibles
to determine if your corporation needs to register in that state.
You can guarantee that in-so-far as Internet sales are
involved, the states are not going to just let all this additional revenue
disappear from their state taxation jurisdiction. Just consider the
case of Geoffrey, a trademark name for Toys "R" Us. The company
that owns the trademark Geoffrey is located in Delaware. The state of
South Carolina claimed that income was flowing out of South Carolina
to Delaware for trademark fees (an intangible); and that they wanted
to collect a state income tax on this revenue. Historically, just having
a trademark in a state didnt create sufficient nexus for tax to
be paid in that state. This case changed that. South Carolina was able
to collect state taxes on the trademark of Geoffrey in its state. Do
you think the states are going to roll over and play dead when they
know you are in the adjoining state doing 35 million dollars a year
over the Internet and you are not paying a dime of state taxes in their
state? They will do everything in their power to try and claim they
have a right to tax part of that revenue! You may find a lot of state
audits of Internet business in years to come. This area is uncertain.
Keep in mind all 50 states already have rules in place to determine
what creates nexus in each state and what is subject to sales and use
taxes in a particular state. Specific information will be coming soon
to our website and you will be able to learn how each state handles
Now, lets find out how the taxation of software
is handled via the Internet. Nexus is key to a states jurisdiction
to tax ESD transactions for purposes of sales and use taxation and income
and income-based franchise taxation.
This articles discusses the tax base and sourcing rules,
formulary apportionment, and compliance, including various proposals
for taxing or not taxing ESD and other electronic commerce.
Your company may be able to achieve a competitive advantage
by understanding the distinctions between "try before you buy"
software, lease, a license, a sale of tangible or intangible property
or the provision for services with the sales tax consequences
varying accordingly. For example, sales of $1 million of software together
with services might generate a sales tax liability of $70,000 or more.
Someone who can structure the transaction to avoid tax could offer a
more affordable package; and the reduced tax may translate into additional
As you know, sales tax is generally imposed on
the retail sale or lease of tangible personal property and certain
enumerated services (designed as "retail services").
Canned vs. Custom Software
Most states view software to be tangible personal property
(subject to sales tax), which must be fungible (i.e., prepackaged, prewritten
or "canned"), as opposed to customized software developed
in a service transaction to meet the needs of a particular customer.
For example, your company might need software developed that makes a
presentation on your products. Nevertheless, otherwise taxable canned
software may not be taxed if delivered electronically. The states
vary widely in their interpretation of custom software, and very few
tax both canned and custom software.
States that apply a narrow definition of custom software
(generally not subject to sales tax) generally require that the software
be developed specifically for one customer (like the above example).
If the software is sold to another company, it looses its custom
characterization and becomes taxable as tangible personal property!
A state also may impose tax on charges for special modifications to
canned software. A few states have a de minimis test whereby software
is deemed custom if the prewritten portion is less than a specified
percentage of the cost of the completed program. States that apply a
broad definition of custom software generally provide that when
modifications merely adapt prewritten software for compatibility
with a customers hardware or software environment, the resulting
package is nontaxable custom software.
Tangible or Intangible Property;
License and Use Issues
ESD, of course, permits purely electronic delivery of
digitized software products. The purchasers rights to use the
digital program, however, may vary widely. For example, a purchaser
(1) might make a single payment for the right to use the software in
perpetuity for business or personal use, or (2) might obtain a license
to reproduce any number of copies for further distribution. Some
states view the purchase of a single copy of a program as a taxable
transaction involving tangible personal property. Also, acquiring
the right to make copies of software may be deemed the nontaxable purchase
of an intangible. Most states view the sale of canned software,
through a limited use license, as the sale of tangible
The terms of the license to use an intangible, and the
degree of use, can dramatically affect the sales tax consequences of
the transaction. In Illinois, for example, canned software is tangible
personal property, and thus its sale is taxable. Under the states
"Retailers Occupation Tax" regulations, however,
a software license that meets all of the following conditions
is not a taxable retail sale.
It is "evidenced by a written agreement signed
by the licensor and the customer."
It "restricts the customers duplication
and use of the software."
It "prohibits the customer from licensing, sublicensing
or transferring the software to a third party (except to a related
The "vendor will provide another copy at minimal
or no charge if the customer loses or damages the software."
The "customer must destroy or return all copies
of the software to the vendor at the end of the license period."
Mixed Sales Transactions
The sales tax treatment often is unclear when a transfer
involves both tangible personal property and otherwise exempt services.
Generally, such transaction requires a determination as to whether it
is a sale of tangible personal property or merely a transfer of property
incidental to the performance of a service that is the "true object" of the deal. Items that are inconsequential or incidental elements
of a nontaxable service contract generally are subject to sales
or use tax when purchased by the service provider. By contrast,
service providers that opt to issue separate charges for such items
generally must collect sales tax.
Maintenance and Support Services
The mixed transaction issue is particularly significant
for companies that sell maintenance and support service contracts along
with software products. Most software publishing companies offer some
form of product maintenance and support. The tax treatment of ESD software
support services generally depends on whether the software is taxable
as (1) tangible personal property in the form of prewritten software,
(2) a professional service in the form of custom software, or (3) other
To determine the optimal method of selling support services,
the states tax treatment of the common components of support service
agreements must be evaluated. The following issues should be considered
in developing alternative methods of selling support services.
Which components of the support service agreements
are subject to sales tax?
How does the tax treatment differ if the components
are sold as optional or separate services?
How does the tax treatment differ if tangible personal
property is (1) used as a medium of transfer, or (2) incidentally
used or transferred in the course of providing the service?
How can the components be delivered so as to minimize
the related sales and use tax consequences?
How should the unbundled components be priced?
Telephone and Electronic Support
Software maintenance agreements generally provide customers
with rights to upgrades in software. Many times those agreements will
include telephone and electronic support via the Internet. Sales of
online service agreements, including software maintenance and support,
may be wholly or partially exempt from tax. Generally, the tax treatment
is based upon content. One of the first things to consider is whether
the online service involves the transfer of software that is incidental
to the service or is the primary object of the service.
For support services with respect to canned software,
taxation often depends on sales terms and invoicing practices. In most
states, sales of telephone and electronic support agreements that automatically
are included with canned software are subject to tax. If the agreements
are optional, then there may be partial exemption of the tax if the
support services are separated on the customers invoice! Nevertheless, even with an optional agreement, telephone and electronic support
services may be taxed if the customer does not have the
option to buy the services separate from the software upgrades.
Software Delivered Electronically
Several states (e.g., California, Massachusetts, South
Carolina and Virginia) provide exemptions for sales of software that
is delivered electronically. In other words, in these statessoftware that is delivered electronically is not subject to sales
tax! It is best to check with each state to determine if electronic
delivery alters that tax consequences.
Other rules and regulations may affect the characterization
of a software transaction the action as a sale or license of tangible
or intangible property. Treasury regulations, for example, and the Uniform
Commercial Code as adopted with various modifications by the state,
may be relevant to the character question.
Federal tax rules. Prop. Treas. Reg. 1. 861-18 concerns
the character of certain transactions involving the transfer computer
programs. Generally, for "the transfer of, or the provision of
services or of Bell-tile with respect to, a computer program," the transaction will be characterized as one of following:
"A transfer of a copy right in the computer
"The transfer of a copy of a computer program
(the use the copyrighted article)"
"The provision of services of the development
or modification of a computer program."
"The provision of no-tile related to computer
The transfer of a copyright generally would involve
what are more of the following:
The right to reproduce a computer program for purposes
of distribution to the public by sale, rental, lease, or loan.
The right to prepare derivative programs based on
a cooperation program.
The right to make a public performance of the computer
The right to publicly display a computer program.
Also under the proposal, a "copyrighted article"
is a "copy of a computer program from which the work can be perceived,
reproduced or otherwise communicated, either directly or with the aid
of a machine or device." A leading industry group, the Software
Publishers Association, has urged states, in applying P.L. 86-272, to
characterize software sales as sales of copyrighted articles as defined
under the proposed federal rules.
The proposal also provides that copyrighted transfer
is a sale or exchange to the extent that substantially all the rights
of copyrights are transferred. If less than substantially all the rights
are transferred, the transaction is classified as the license generating
royalty income. For a transfer of a copyrighted article, "[a] transaction
does not constitute a sale or exchange because insufficient benefits
and burdens of ownership of the copyrighted article have been transferred...will
be classified as the lease generating rental income. Significantly,
the proposal states that in applying the rules, the means of the transfer-electronic
or otherwise-are not to be taken into account.
Sources for sales tax purposes. For tangible
personal property, most states impose sales tax on the transfer title
or possession or both by the seller to the purchaser. Generally, sales
tax is imposed to pay a place of delivery, determine without regard
to shipping terms. The taxes usually apply even when the purchaser immediately
transports the goods outside the taxing state.
Some jurisdictions deem delivered to occur at the sellers
location if the goods are picked up there by a common carrier acting
as the purchasers agent, but not if picked up by a common carrier
acting as the sellers agent. Thus, for example, a non-California
purchaser and contracts with a common carrier to pick up goods at a
vendors San Francisco facility will be subject to California sales
tax. By contrast, delivery does not occur in the state if they could
to pick up by common carrier acting on behalf of the vendor and delivered
to the purchasers out of state location.
Drop-shipment transactions. Conflicting requirements
may apply in determine which states can impose sale tax on goods purchased
in one state and delivered by the seller to the purchasers designee
in another state. A company may face a sales/use tax collection duty
in two states if each deems delivery to occur in its own jurisdiction.
This problem is largely administrative, however, since the risk of double
taxation has been largely eliminated by the allowance of a credit against
use tax for sales and use taxes paid to other states.
Sourcing and ESD. It is difficult to apply these land-based
delivery principles to electronic commerce. For example, when software
is electronically delivered to an online address, the software vendor
must obtain the place of delivery or the customers residence by
other means. In practice, the vendor must rely on information provided
by the customer to determine the destination of the sale.
Income Tax: ESD and formulary apportionment. If you
operate a company that does business in different states you must determine
where the companys corporate franchise and income tax liabilities
will occur. There is a three-factor test to determine how much tax you
owe in each state. This formula is based on; the companys payroll,
property and sales in each state. If you do business in three states,
the total of your payroll, property and sales should add up to 100%.
Then you would pay taxes in those states occurring to the specific percentage
allocated in each state.
Because of ESD the sales factor and how that is handled
in each state becomes interesting. As we mentioned earlier, software
is treated as tangible personal property. This income is sourced to
the state where the sale occurred. When software products are treated
as services or intangibles, many states source sales of services and
intangibles to the sellers location! The problem is that a most
states will source the sale of services and intangibles to the place
where the income-producing activity occurs, based on the where the headquarters
is located. While some states will do the opposite, they will source
it to the location of the buyer. Double taxation can be a real issue
since some states have adopted rules that increase the relative weight
of the sales factor.
As we mentioned in earlier articles, it is important
to understand Public Law 86-272. This says that in you are selling tangible
personal property in other states only on a solicitation basis, you
are not considered creating nexus in those states. The throwback rule
provides that if the taxpayer is not taxable in the destination state,
sales of intangible personal property are sourced to the state from
which the goods are shipped.
For ESD, the initial question of whether the taxpayer
has sold tangible personal property remains open, given the lack of
clear guidance in the area. The states definitions of tangible
personal property are not consistent and, thus, software vendors should
carefully consider the various state rules in calculating apportionment.
The key in all this uncertainty is compliance. It is
critical for small businesses especially to know the rules for keeping
records for all your business done via ESD and to survive an audit.
Electronic recordkeeping. In March 1996, the Federation
of Tax Administrators (FTA) released a proposed model recordkeeping
and retention regulations (the "model regulation") that was
developed by a coalition of state and industry representatives. The
proposal is being adopted by a growing number of states. These rules
seek to ensure that taxpayers maintain all records necessary to determine
the correct tax liability under state statue. Here is an example:
The taxpayer may create files solely for the use
of the state taxing authority but should document the process that
created the separate file to show the relationship between that
file and the original records.
"Machine-sensible records" (i.e., a collection
of related information in an electronic format) must contain sufficient
transaction-level information so that the underlying details relating
to individual transactions may be identified and made available
to the taxing authorities on request.
There are a couple of different software programs recommended
to track your state tax planning. One is by Vertex, Inc. It has two
software packages for sales and use tax compliance.
Recently, the Internet Tax Freedom Act was passed.
It imposes a three-year moratorium on various types of state and local
taxes, licenses, and fees on the Internet or interactive computer services.
Nevertheless, the law grandfathers state and local taxes "generally
imposed and actually enforced prior to October 1, 1998. Existing state
and local taxes that are applied equally and fairly to both electronic
and nonelectronic commerce are excluded from the moratorium.
The National Tax Associations Communications and
Electronic Commerce Tax Project (the "NTA tax protect") is
considering several alternatives to the current tax regimes. The NTA
tax project recently reached a milestone with its approval of a one-rate-per-state
sales tax formula for all commerce. This agreement is but a small step
toward overall consensus.
There are alternative suggestions that require federal
legislation. One suggestion concerned nexus over out-of-state vendors
based on the purchasers billing address. An alternative to the
traditional nexus standard, this proposal sought to implement a taxing
regime in which an out-of-state vendor of electronically transmitted
information and services would have nexus in the state corresponding
to the purchasers billing address. The vendor thus would have
to make a reasonable and good faith effort to determine that address.
Absent the purchasers billing address, default
rules would apply to assignee the sales and use tax base to certain
states. Two rules were suggested-the "throwback rule" and
the "throwaround rule"-under which the vendor would be presumed
to have met any tax collection responsibility.
Throwback. The throwback rule would require the vendor
to collect from the purchaser sales or use tax that may be imposed
by the state in which the vendor has its principle place of business.
Throwaround. The throwaround rule would require a
vendor to collect sales or use tax based on the average rate for sales
taxes collected by the vendor on all sales of electronically transmitted
information or services during the preceding calendar year. The vendor
then would remit the tax to each state in the same proportion that
the prior years taxes were paid to the state.
Alternative under traditional nexus standards. Taking
traditional nexus standards into consideration, another alternative
involved the situs of a transaction. Two categories would be established:
Purchases either for personal consumption or by a
business not known to be registered in the particular state.
Purchases by a business known to be registered in
Different tax reporting rules would be established for
each category. A retailer would be relieved from collecting and remitting
tax for sales involving registered businesses.
The NTA tax project also discussed the use of a congressionally
implemented "state tax information clearinghouse." The clearinghouse
would enhance enforcement of existing use tax laws by requiring central
reporting of interstate, Internet sales of taxable property or services
by vendors that do not maintain a physical business presence in the
jurisdiction into which the sales are made. This procedure would apply
only to transactions with respect to which no sales or use tax was collected
There is another group called the Software Industry
Coalition. They believe that the collection responsibilities for Internet
Transactions should be placed on the taxing jurisdictions. Their proposal
notes that for digital products that are picked up electronically by
the buyer from the sellers website, no buyer zip code is required.
In that situation, it remains to be seen whether the buyers state
can impose a use tax collection obligation on the buyer, or whether
the sellers state will even consider the digital products to have
been exported from the state.
Yet another group, Wade Anderson (Tax Policy Director
in the Office of the Texas Comptroller of Public Accounts) has proposed
a nationally assessed state sales tax on interstate electronic commerce
that offers a unique approach focused on international aspects of sales
and use taxation. Implementation of portions of the proposal would require
federal legislation. The most unsettling aspect of this proposal is
the fact that an out-of-state sellers without physical presence in the
taxing state provide customer information to the state, or to a federal
agency, to enable the state to collect use tax directly from its residents.
This brings up some sensitive privacy issues.
By another proposal, there would be a single national
tax rate for sales/use tax collections by Internet sellers.
In conclusion, there are many different groups trying
to adopt a new proposal to solve this complex Internet taxation issue.
Also, the success or failure of the Internet Tax Freedom Act will also
play a role in the future of the Internet.
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